We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
Contact the Author: accruedint at gmail.com

Wednesday, April 25, 2007

For the second time in the last 6 months, the Wall Street Journal is mongering rumors on Alltel. The first was that they would be taken private. Here was my take on that. Now they are to be bought by AT&T. We'll see. Both rumors appear to be based on nothing more than the imagination of a journalist.

The corporate bond market continues to gather strength during April. After spreads gappedwider when the stock market melted down on 2/27, most investment grade corporate bonds have recovered their losses.

What happened in the corporate bond market in the days immediately following 2/27 and their subsequent recovery tells us a lot about what is driving corporate bond spreads. First an illustration. This graph shows the spread of three long-term, large issue corporate bonds. Goldman Sachs (rated Aa3/AA-), AT&T (A2/A), and Comcast (Baa2/BBB+). Since none of these three have had particularly good or bad news lately, they are all good examples of where corporates in general are moving. I did a basic normalization of all three by starting their spread at 100 and moving it up or down from there. So any point where any of the blue lines are below 100 (dashed horizontal line), the spread tightened from its initial 2007 level. The red line is the VIX, which I'll get to in a minute. The vertical dashed line is the 2/27 mini-crash.

First, let's agree on three basic premises.

Most traditional money managers are negative on the corporate basis, and have been for some time. Many (if not most) are looking for some catalyst that will push corporate spreads wider.

Hedge funds and other speculative investors are the marginal buyer or seller of credit risk on any given day. Many hedge funds use quantitative models in building arbitrage strategies involving the corporate bond market. The VIX (or some similar measure) is a very common input in such models. Hedge funds are also involved in paired trades where one is long or short the stock and the opposite of the bond.

There remains a tremendous level of global liquidity.

Bearing these points in mind, think about the reaction on 2/27 and the days thereafter in the corporate bond market. Assuming point 2 is right about arbitragers being the marginal buyer or seller on a given day is correct, the corporate market was most likely driven by hedge fund selling during this period. Anecdotal evidence I heard at the time backs this up: dealer desks told me they couldn't sell protection fast enough, and there was very little in cash bond trading. If traditional money managers (or even retail) had been leading the sell-off, there would have been more trading in cash bonds.

So why would hedge funds be buyer protection aggressively in the face of a 400 point drop in the Dow? It sounds like a silly question, because obviously if the Dow is dropping like that, there is some kind of repricing of risk going on. But consider what happened since 2/27. By March 21, the Dow had recovered more than half of its losses from 2/27. But these three corporate bonds did not start tightening meaningfully until mid-April. Today, the Dow is over 220 points higher than its pre-2/27 high. Our selection of corporate bonds are all still wider than before the 2/27 rout.

So those that would chalk the whole thing up to risk repricing must suppose that the stock market and the bond market have divergent opinions of the same set of economic fundamentals. Maybe, but I don't think Occam would approve. What if it isn't really fundamental? If it were entirely technical, then it isn't hard to imagine that the corporate and equity markets would go in different directions because they're subject to different technicals.

Back to the three premises. If portfolio managers are generally negative on corporate spreads, they are likely to view a sell-off as lasting. Let's face it, most people's reaction to market events is biased by their positions. So they don't buy on the dip, not right away, because they see it continuing. They probably don't sell what positions they do have either. They are already short of their benchmarks and are loathe to deviate too much. On the other hand, equity PMs aren't necessarily as bearish. So maybe they are more aggressive about buying on the dip. Still, this doesn't explain why the rally in mid-April. If PMs aren't doing anything, then corporate spreads would be hanging wider.

Meanwhile, there is still this ocean of liquidity. Cash will be invested someplace. But this massive liquidity doesn't come into the market on any given day. It just sits there, buying up a certain amount of bonds each day. So while the liquidity might explain why corporates didn't get even wider, I don't think it explains the delayed rally. It isn't like the liquidity showed up in mid-April after sunning in Florida during March.

So we're back to speculators driving the market. Why would they change their minds on corporate risk so quickly but at the same time, not change their minds concurrent with the stock market rally?

My bet is that some fast money is following the VIX. Look back at my graph. The VIX spikes higher from 11 to 18 on 2/27, corporates sell off. The VIX stays high until the end of March, averaging 15.5 for the next 20 trading days, corporate spreads stay high. The VIX falls lower at the end of March (its averaged 12.9 in April), and corporate spreads get a little better. But the VIX is still well above its recent low of 9.9, just as corporates spreads remain above their recent tights.

Now, I don't know of any quantitative spread model that doesn't involve the VIX, or some other measure of stock volatility. The theory is that higher VIX levels indicate economic uncertainty, which is bad for corporate bonds. So your model says sell corporates as the VIX is rising, and buy corporates as its falling. But looking at this graph, doesn't it look like these traders got whipsawed? If you add to this that CDS were even more volatile than bonds over this period, its likely that some traders really got whipsawed.

I am not here to bury quantitative models. I use them myself constantly. But I think one needs to be careful when using a measure of the market's emotional state as an input into a quant model. The market is manic-depressive. Guessing that today's mood is an indicator of tomorrow's mood is dangerous. So if any trader did get whipsawed trying to trade the VIX while ignoring the economics around him, it isn't the model that's the fool. Its the fool that followed the model.

Tuesday, April 24, 2007

I think the answer is yes, but not because of the issues brought up on the article. On the site, I made the following comment:

I think the globalization impact on monetary policy has more to do with capital flows. Take for example Japan. It appears low interest rates in Japan have resulted in capital outflows without influencing consumer spending. Whether you are a monetarist or Keynesian, consumers have to spend more currency in order for prices to rise. If shifts in interest rates result in capital flows and not consumer activity, the ability to influence consumer prices is diminished.

In addition...

Globalization may be influencing wage levels more directly than goods prices. If wages don't grow (in nominal terms) you can't have inflation. In order for the aggregate price level to rise, consumers have to actually spend more. That requires either wages to rise or the savings rate to decline. If we agree that the savings rate will have a hard time declining in the U.S., we need wage growth to have inflation.

Rampant use of U.S. dollars for purposes other than U.S. consumption is influencing the U.S. money supply. I'm particularly thinking of flows from immigrants to foreign persons (i.e., sending dollars home that get spent in the foreign country), as well cash held to support dollar pegs.

Anyway, those are my thoughts. I think the net consequence of this is that monetary policy takes bigger swings than it did in the past, and that fighting deflation will be harder than fighting inflation.

Sunday, April 22, 2007

Credit Default Swaps (CDS) are fast becoming the dominant vehicle for trading credit risk. In this piece, I'll go over the basic features of a standard CDS contract and why they are easier for many traders to utilize over cash bonds.

At the onset of a CDS contract, the buyer of the contract agrees to pay a fixed spread to the seller of the contract. For corporate CDS, the spread is paid quarterly, so if the spread agreed to is 40bps, the seller would pay 10bps per quarter. In exchange, the seller agrees to buy a specified bond (or other instrument) from the buyer at par in the event of a default. Most CDS contracts have a five-year term, but other terms are possible. If CDS are quoted without a term specified, assume its five years.

A CDS is a lot like an insurance policy. This is why CDS are also called protection. The spread paid by the buyer is like the insurance premium. If there is a default, the buyer is essentially made whole because s/he gets par for the bonds. Just like if you have homeowners insurance and you have a fire, the insurance policy pays you whatever your stuff is worth.

The CDS contract references a specific bond (or bank loan). For example, the 5-year Alltel CDS references the AT 7% '12. In the event of a default, the seller will be buying some bond which is pari-passu with the reference bond. The buyer of protection doesn't have to actually own this bond. In fact, the buyer of Alltel protection might be a bank with which Alltel has a credit line. The bank knows that if Alltel gets into trouble that the credit line will be drawn down. But they also know that the CDS contract spread will widen substantially, and they will have a profit in the contract. If Alltel actually defaults, they can buy the bond in the secondary market at a steep discount, then sell it to the seller of protection at par and make a huge profit.

CDS are also a vehicle for speculating on a credit. The buyer of protection is essentially short the credit, while the seller is long. Buying protection may be easier than actually finding the bonds to short. Similarly, selling protection may allow one to get exposure to a credit with greater leverage than would otherwise be the case. CDS also have no interest rate exposure, so someone who wants get get long or short a credit can do so without needing to work about hedging credit risk on either the short or long side.

In fact, selling CDS protection in consort with owning a LIBOR floating asset is exactly like being long a 5-year FRN (if you ignore things like financing costs). Think about it, with the 5-year FRN, you'd get paid LIBOR plus some spread so long as the credit doesn't default. If it does default, you suffer the difference between par and the recovery rate. The CDS/LIBOR combination has exactly the same payout structure. For that matter, selling protection is also very much like buying a 5-year fixed corporate and heding with a 5-year LIBOR swap. You wind up just collecting the spread. For this reason, the CDS should have a similar spread as cash bonds when compared to LIBOR swaps.

In practice, CDS can divert from cash bonds materially for a couple reasons. First, the CDS may be deeper than the cash bonds, and in a fast moving market, the CDS may appear to lead cash bonds. In reality, this may be that the cash bonds aren't trading. More recently, we've seen CDS widen in LBO situations while the cash bonds tighten. This is normally because of covenants in the cash bonds which will result in a make-whole call. This post on the Equity Office Properties transaction describes this possibility in more detail. The same thing happened recently with First Data Corp's LBO. Even with companies rumored, like Alltel, to be possible LBO candidates and have attractive covenants, the CDS tend to under perform cash bonds.

Another reason is a cute little arbitrage involving discount priced bonds. Take Ryland 5.375% '15. This bond was issued in January of 2005 when the 10-year was 50bps lower, and troubles in the housing market has pushed the spread about 75bps wider. As a result, this bond has a dollar price of $92. So let's say I buy the bond and buy protection on it. If it defaults, I get paid par for my bond. I make 8 points. If it doesn't default, and the carry isn't negative, nothing happens. I get paid the yield on the bond, but probably gave up all the spread buying the CDS. So basically its a trade that has a high probability of doing nothing, but a small possibility of producing a nice return. Upside with no downside = arbitrage. Anyway, so CDS that reference discount priced bonds tend to be wider than those referencing premium priced bonds.

Feel free to comment if you have questions, or e-mail me at accruedint AT gmail.com.

Thursday, April 19, 2007

First a correction. Tuesday I claimed that Sallie Mae's leverage would decrease because of contributed equity. If I had actually thought about what I was saying for a minute I would have realized that's not right. As an Anonymous commenter pointed out, the company is being purchased for $25 billion, so all that purchase cash is going out the door. That includes the $8.5 billion in equity contributed. So debt increases by $16.5 billion and leverage increases accordingly.

Commenter mOOm asked whether equity goes negative here, since the company only had around $4 billion before the transaction and if they increase liabilities by $16.5 billion, but decrease cash asset by $25 billion, that'd seem like negative equity. I think the way the accounting of this works is that the premium paid for the company over book value goes in as a credit to goodwill. My knowledge of merger accounting is limited to the CFA exam 6 years ago, so I could be rusty on this. Anyone who knows this better than I is encouraged to leave a comment. Now, mOOm's may ultimately be right in a way, since goodwill is an intangible asset anyway. I tend to use interest coverage ratios of various types when analyzing a company's leverage anyway, since the "real" value of a company's assets is always questionable.

Now on to the merger itself. That's right, I'm calling it a merger. Because this does not walk or talk like your typical financial engineering-type LBO. By extending a huge credit line to Sallie Mae, JP Morgan and Bank of America are acting more like strategic buyers. Think about it, Sallie currently has $112 billion in debt outstanding. Would these two banks, in the normal course of business, extend a $200 billion credit line to a company like Sallie? I seriously doubt it. They are only doing so because they have a strategic interest in the company. I think what JP Morgan and Bank of America are doing here is trying to better tap the large student loan market. They realized they couldn't do it organically, and they didn't want to buy up SLM themselves and suffer the drastic increase in leverage on their own balance sheets.

So they get JC Flowers and Friedman Fleischer & Lowe together and buy SLM jointly. The two banks essentially benefit from the fee income stream of Sallie's student loan business, but keep the whole thing off balance sheet. GAAP accounting (and bank regulators) will not consider SLM's debt load as part of either bank because its theoretically non-recourse. De facto, the credit line changes the recourse story entirely. If SLM struggles with all that leverage, they'll take down the credit line and JP Morgan and Bank of America will be holding the bag. Again, this smells a lot more like a strategic merger than a typical LBO.

But this is a bond blog not a private equity blog. So let's talk credit ratings. I've heard different theories. One is that SLM will wind up going to a B-rating. Ugly. Under that scenario, they can get away with the low rating by simply securitizing everything. Here's what I don't get about that theory. Once they securitize the student loans, there is no liability or asset on their books. They've simply collected a fee and then sold off the risk to someone else. They may retain a servicing fee (I'm assuming, I don't know much about student loan securitization), but student loans are floating, so there isn't the same hedging risk that mortgage servicers face. But in that scenario, I'm not sure why they'd suffer a big credit downgrade. I mean, they'd simply be transitioning from a S&L type model (borrow at X, lend at X+200bps), to a conduit model (collect fee for facilitating the loan, then sell the risk to the public). One isn't necessarily more risky than the other. Obviously there could be more to the plan, I'm just saying, altering their core financial strategy doesn't automatically mean they should have a weaker rating.

Another theory for a junk-rating is that their current debt is subordinated to the new debt. To me, whether that justifies a junk rating or not depends on how much of that credit line they've tapped. Typically, subordinated debt is notched from the senior debt. If the credit line isn't used at all, there is going to be a small amount of secured debt and a large amount of unsecured debt. I think in the absence of the credit line, the ratings agencies would simply notch the old debt one notch, maybe two. The company has $96 billion in student loans, so to secure $16.5 billion doesn't put the old loans in such bad shape. Obviously if SLM takes down $100 billion of the credit line, then that's all out the window. But why would they do that right off the bat? And I don't think the rating agencies will rate the company's leverage based on the credit lines they might use. If they did that, then why not rate every company on the bonds they might sell to the public at any time? I think they will only consider the credit line to the extent that the company says they intend to use it.

So I could be wrong about all this, but my read on this is that the credit downgrade won't be as bad as what's priced in right now. There is current a rush to the exit, as a downgrade to junk would cause massive forced selling. Again, I could be wrong, but I think patience will be rewarded here.

Tuesday, April 17, 2007

In case you are living under a rock, Sallie Mae is to be taken private by four investors. SLM Corp., which is their less known official name, might just be the most prominent investment-grade bond issuer to be taken private. While SLM is not a major component of the Lehman Aggregate, they are a major issuer of floating-rate notes (FRN). As such, I'd suspect this transaction will touch certain investors not used to dealing with this kind of corporate event risk.

SLM's bonds have widened substantially. FRNs in the 5-year range were trading around LIBOR +25ish, now more like +120. Its an extremely volatile market, and so the spread is changing as I'm typing this. A 100bps move on a 5-year bond is about 3 points.

I'm very surprised by this transaction. Although SLM has come up before in LBO talks, I didn't believe the company could withstand a large increase in leverage. But upon looking at what little detail has been made public so far, the buyout is gong to be funded with $16.5 billion in debt and $8.5 billion in equity. Looking at SLM's balance sheet, they currently have $112 billion in debt versus $4 billion in equity. So after the transaction, they'd have $128 billion in debt versus $12 billion in equity? That's a decrease in leverage from 28x to 10.7x.

It also occurs to me that the backup financing that JP Morgan and Bank of America are providing may be to help ensure an investment-grade rating, not as has been reported, to protect against the possibility of a junk rating. Consider that if BofA and Morgan thought the company would be junk rated, then the credit line would immediately be used. That makes the credit line de facto equity contributed to the deal, and would greatly decrease the IRR on the transaction.

On the other hand, if the ratings agencies see that there is a large, untapped credit line, the risk of a sudden bankruptcy greatly diminishes. In fact, the credit line is nearly 2x their entire loan portfolio. The ratings agencies should allow for greater leverage when the company has ample liquidity available to them.

With any private transaction, the devil is in the details, and we haven't seen too many of those yet. My quick take is that SLM winds up getting downgraded into the Baa/BBB range, but no further. That should allow the bond spreads to tighten from here.

Friday, April 13, 2007

Both my and the market's reaction to the initial Fed release on March 21 were wrong. It sounded to me like the Fed made a fundamental shift in their rate strategy when they dropped the phrase "additional firming... may be needed" from their statement. Logically, if the Fed saw the need for a cut in the near future, they'd start by dropping that phrase.Reading the actual minutes, released on Wednesday, you don't get the same impression. It sounds more like the Fed sees some increased risks to the downside, but also sees stubbornly high inflation indicators. Reading between the lines, I think the Fed wanted to acknowledge their willingness to cut rates if it indeed comes to that, but we aren't there yet. Conversely we could say the Fed wanted to let the housing bears (and member banks) know that they aren't ignoring the housing situation, particularly the growing sub-prime problem. If a little boost to liquidity would help, then they may well oblige. But we aren't there yet.So while I was wrong, kudos to people like David Andrew Taylor who were right. David posted on his blog right after the release that he still read the Fed as hawkish. I was proud of myself for getting the initial market reaction right, but it looks like that was merely the initial skirmish. David won the war.In terms of actual trades, this was a case where I may have been wrong, but still made money doing it. I had moved my duration slightly lower in the last week of March. Rates have risen between 10bps since then. I'm positioned for a steepener, and even though we've flattened from +6 (2-10) on 4/2 to +1 now, the bigger picture is the move from -19bps in November to +1 now. I'm also long financials, which have outperformed considerably the last 5 days. MBS are also having a solid month of April so far. Most of my bets play out well in a low volatility environment, so the Fed on hold scenario is just fine by me. I also think the 10-year has to rise more from here, with no move from the Fed, I've got to think the 10-year moves toward 5.25% by year-end. Whether it gets there or not depends on whether some of the housing headlines calm down and whether inflation figures allow the Fed to remain on hold. If it develops where they could actually hike, then the curve re-inverts in a bearish fashion.But taking everything on balance, I still like the Fed to cut twice by year-end. I think that inflation will indeed subside. At that point, the Fed can turn their eyes to the banking system, and will conclude that 50bps of cuts will take a lot of sub-prime related pressure off. If I'm right about that, I think the 2-year stays right where it is and the 10-year sells off to 4.90%. If you read this post from the afore mentioned David Andrew Taylor, he makes a logical case for rising consumer spending from here, which would normally create inflation pressure. I believe monetary policy is no longer accommodative, and I think consumer credit conditions have tightened. Both of these should be disinflationary, and I think this is what will win the day. David is taking a Keynesian approach, while I'm walking down Milton Friedman's path. We'll see who is right.

Wednesday, April 11, 2007

In response to a recent comment, I made the off hand remark that the average bond mutual fund has 200% turnover. I looked it up in Morningstar's database, and in fact, the average turnover is 203%.

Regular reader Vivek asked me about the common claim that stock managers trade too much. Given that transaction costs are undoubtedly higher in the bond market compared to the stock market, and given that the average stock fund's turnover is only 84% (according to Morningstar), does that mean that bond mangers trade too much also?

First on the transaction cost issue. There are two basic types of transaction costs: overt costs (commissions) and market impact costs. The first is obvious in the stock market, but not so much in the bond market. A bond buyer rarely knows what commission their broker is being paid. This is because the commission is embedded in the price. But even in the most liquidmarkets, where the bid/ask is only a tick, that's equivalent to a stock commission of 3 cents/share on a $100 stock. I know institutional buyers can do better than that in most cases. So while the Treasury and TBA mortgage market might have the same transaction costs as stocks, corporates, agencies, and municipals certainly don't.

In terms of market impact, that's a tougher question. I don't trade stocks professionally so I'm loathe to make a ill-informed opinion about that market. 99 times out of 100, a medium sized bond manager (say $1 to $10 billion) doesn't do trades large enough to influence the market at all. The exception might be in a off-the-run corporate where the trader is dead set on a specific bond. In order to find the issue, a brokerage might have to entice a current holder of the bond with a particularly strong bid. Anyway, that's a rare circumstance, and a smart trader can mitigate this kind of problem.

But trading is very different in bonds versus stocks. Consider the most fundamental reason why one invests in a bond: the income generation. Consider also that with any fixed rate, bullet bond, the income generation is known at time of purchase.

This makes it very easy to isolate the differences in risk between two bonds. For example, let's say that I own a Bear Stearns bond maturing in January 2017. Let's say that Lehman Brothers also has a January 2017 bond. Both are fixed rate, non-callable issues. Both have identical creditratings. Let's say that I can sell my Bear Stearns bond at a yield of 5.70%, and can buy the Lehman Brothers bond at 5.80%.

I've increased yield by 10bps, and the only change in risk is now I'm exposed to Lehman's credit as opposed to Bear's. Let's say that I think the companies are essentially the same risk, which isn't much of a stretch. So I've done this trade and picked up the extra 10bps.

Is this example realistic? Yes. The 10bps differential might be a bit on the high side for an obvious trade like this one, but stuff like this is available all the time in the bond market. Why does it happen? Typically because there happens to be more supply of one name versus another (such as it was just issued), or that a particular dealer is short one name and really needs to buy it.

Other examples might include trading in the same name but altering maturity, trading in the same name but going from fixed to floating, trading in the same name but going from senior to subordinated, etc. People do similar trades outside of the corporate market as well. Forexample, I did a series of trades involving one-time callable agencies back in 2004 and 2005. I had the view that the short-end of the curve was going to rise and I could therefore sell agency option risk and gain extra income.

A one-time callable is a bond which can only be called on one single date. Once that date passes, there is no more option risk. With all of my bonds, that date passed without the bond being called, because as I correctly forecasted, short rates just kept rising and all of the calls were out of the money.

Anyway, once the call expired, the value of the bond has increased by the value of the option (now worthless). But maybe I still had the same view on the short end of the curve, so I went ahead and sold my old bonds and bought new callable bonds. Let's say that the new callable bond I bought yielded an extra 50bps versus the bond I sold. If yields rise, the call expires worthless and I get to keep the 50bps in yield plus the bond will appreciate once it becomes a bullet.

So what's my point with all this. Its that when trading one bond for another, the relative value is more certain than when trading one stock for another. That is because the fundamental reason for owning a bond can be summed up in a mathematical formula -- yield. The price appreciation on a given stock is far less certain. So if I sell a Bear Stearns bond and buy a Lehman bond and pick up 10bps in yield, I know exactly what I gained in the trade: 10bps. If I did the same with the stocks, it all depends on which one appreciates more than the other. That's far, far, far less certain.

So that's one reason why turnover is logically higher in bond portfolios versus stock portfolios. In fact, bond managers who don't take advantage of these kinds of opportunities when appropriate are probably giving away performance.

There are two other facts of bond market life that inflate the turnover statistic. First, bonds create cash flow. While it would be possible to literally have zero turnover in a stock portfolio for several years, bonds mature, pay sinking funds, get called, MBS prepay, etc. So a bond managerhas to do reinvest cash even if s/he is trying to keep turnover as low as possible.

Second, most managers use Treasury bonds as a means of locking in spreads. This is how it works. Let's say that I own 10-year Rescap bonds, and I no longer like the credit and want to sell. So I collect bids from dealers in spread vs. the 10-year Treasury. When I go to actually sell the bond to the winning dealer, I ask the dealer to also sell me the same amount of the10-year. Now in selling the Rescap issue, I didn't really want to decrease my overall credit allocation. So now I want to spread out that cash into various corporate names I already own. I go out into the market and find the best offers on each of the names I want, and as I execute those buy trades, I simultaneously sell the 10-year to the executing dealer. Why do managersdo this? Because it prevents a sudden move in the overall Treasury market from impacting the success of the trade. If I were to sell the Rescap bonds at 10AM, and there were to be a huge rally at noon, then without buying the Treasury bond in the interim, I might be forced to buy my other corporates at higher prices. In effect, this would be like getting poor execution onthe Rescap bonds. As you can see, this practice results in what was 2 trades becoming 4.

I hope this explains why bond managers trade so much, and why it might not be such a bad thing.

Friday's market action in response to the strong non-farm payroll report seemed to take a Fed cut off the table in 2007. But not so fast. Don't forget the following:

Job growth is a lagging indicator. Firms don't tend to lay people off until demand has slacked for their products. So the slack demand tends to come first, job losses second.

The particular pressure on the financial system today relates to mortgage lending. A small number of Fed cuts may be especially potent in response to that specific problem.

So I still think there will be 1-2 cuts this year. At least some people in the market agree with me, as we've had small rallies the last two days and steepened by 1bp. We'll know more at 10AM when the minutes are released.

My prediction would be a bull steepener. Friday's action clearly tells you the street is lined up for a hawkish tone to the minutes. Remember, they were set up for a hawkish initial statement from the Fed and didn't get it. My bet is on the same today.

I will say for those who want a cut in June, its too late for that now.

I had posted several days ago that it was time to shorten duration. That's playing out well. My theory was based on the observation that the 10-year kept failing to break 4.50%, and that there was no justification for more than 2-3 cuts. The question is whether Friday's action was enough to bring risks back into balance.

Unfortunately, due to the holiday, I suspect there wasn't a lot of real money traders around to participate. I think without validation from long-term investors its hard to read. Since my longer term bias is for the 10-year to rise to around 4.90% I'm sticking to my slightly lower duration stance for now.

Friday, April 06, 2007

Price action in the Treasury market continues along the trend I discussed on Wednesday. Early in the day on Wednesday, the Treasury market tried hard to rally, pushing about 1/4 point higher. But as the day past, the rally faded and finished the day essentially unchanged.

This followed through on Thursday. The market opened up slightly weaker, and it pushed even lower as the day continued.

Granted, we're talking about relatively small moves. But its reinforcing that there is no support for prices here. The small rally on Wednesday was met by selling and the weakness on Thursday was reinforced.

Corporate bonds moved tighter on Thursday. My sense is that this was a pause, not an actual reversal in the trend. However, if we get a few days of strength in the corporate market, it will force real money account to come in, and that will push spreads considerably tighter quickly.

By popular request, I have created a second blog on bond market slang, jargon and cliches. Find it here. I plan to update it regularly with new definitions. I'll try to also post links within posts I make here to help translate my bond geek speak.

Wednesday, April 04, 2007

I've had several comments on the level of bond market jargon I use. Mostly less complaining and more people asking for definitions. So I've decided to soon create a piece for this website on bond market jargon. I'm thinking less about general investment terms (try investopedia for that) and more about the real bond geek speak that I throw around way too often.

If you have any terms you'd like to see defined, please post a comment here or e-mail me at accruedint *at* gmail.com.

Yields are rising. In the last 15 sessions, the largest rally in the 10-year has been 1.4 bps and only 5 days where the rate fell vs. 10 days where rates rose. Two of those "rally" days involved less than 1/2 bps move. This kind of slow leak higher is indicative of a buyer strike. Fast money pushed rates lower immediately after the 2/27 stock market mini-crash. But there has been no support from real money buyers.

Corporate spreads are widening. Even a big rally in the stock market yesterday couldn't spark a generalized bid for corporates. Dealers are feeling around for the right level on many issues, and as a result, bid/ask spreads are wider. Most investment managers have expected wider corporate spreads eventually since 2005. So for the moment, they are content to sit on the sidelines and pat themselves on the back for making the right call. If it takes you 2 years to be right, are you really right? Regardless, I see corporate spreads leaking out further, but on the first sign of a sustained rally, PM's who are short are going to rush in and spreads will move tighter quickly.

The strategy I'm employing is to be short duration slightly, long MBS, neutral on corporates with a bias towards higher quality names.

S&P cut First Data's bond rating to BB+ from A on the news. Pretty harsh. However their bonds have tightened dramatically on the widespread belief that the bonds will be tendered. Their 4.95% due in 2015 was 130/120 on Friday, now somewhere in the 80's. The bonds have a 20bps make whole call.

First Data has a non-subordination covenant in their debt. This means that they cannot pledge assets to support the credit of new bonds without similarly securing existing debt. I've mentioned this covenant before, as Alltel has the same restriction.

Here is why this is important. First of all, let's say you are a bond holder for ABC corp. Your bond is ABC corp's only piece of debt. ABC has a large factory, owns several warehouses, and owns the land under each. In the event ABC goes bankrupt, all of these things have value and can be liquidated in bankruptcy court. The proceeds of the liquidation would go to senior bond holders.

Now some enterprising investment banker comes to ABC and tells them that they can issue new bonds secured directly by their hard assets, get a very attractive rate, and use the proceeds to buy back stock. The old bond holders get completely screwed. Not only has ABC greatly increased their leverage, but now those nice assets you thought you could liquidate in bankruptcy will instead go to the new bond holders first. In essence, you've just become a subordinated creditor!

Ford recently did just this. They were unable to get a extension of their credit lines without securing the lines with hard assets. Existing creditors became de facto subordinated to the banks offering credit lines.

Now let's turn to the subject of LBO's. Typically an LBO results in a large enough increase in leverage to merit a junk rating. Witness FDC's new rating. But all that new leverage doesn't come from thin air, the firm has to either issue bonds or take out bank loans. For a BB-rated firm, the cost of issuing unsecured bonds may be intolerably high. And banks will likely insist on some level of securitization. Unfortunately, there may not be enough assets to secure all bonds equally and at the same time satisfy lenders.

So the post-LBO company may want to take out bank loans which are secured then issue bonds which are unsecured. But they can't do this without getting rid of the non-subordination covenant. This is accomplished through a consent tender. Basically the company offers to buy the bonds from existing holders at a large premium (usually at or near the make-whole level). Any holder that agrees to the tender, also agrees to eliminate the covenant. Most bond holders will be happy to sell their bonds and don't give a damn what happens to the covenants after they've sold their holding. If enough holders consent (sometimes just a majority, sometimes a super majority), then the covenant ceases to exist.

Notice this is marginally cheaper than just doing a make-whole call. First, you might get bond holders to agree to a price slightly lower than the make-whole level. That depends on how well organized the holders are. Second, some bonds will be tied up in non-tradable situations, like a CBO. These holders won't tender, but would have automatically participated in a make-whole call. Plus some holders might not tender because they are brain dead. Never underestimate the degree of brain deadedness in the bond world.

Any bonds not tendered will get murdered. Because not only have the bonds been downgraded severely, they've also been subordinated by the new secured debt. Also, these old bonds are often the only reference obligations remaining for CDS holders. So CDS holders get murdered also.

Note that the CDS becomes a poor hedge for the cash bonds in this case. Say a dealer desk got short a cash bond in FDC to fill a client offer wanted. The trader also shorted protection in the CDS to hedge his short cash position. Now the CDS is wider and the cash bonds are tighter both by wide margins.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.